Club Med and the Sun Belt: Lessons from adjustment within a monetary union

Uri Dadush, Zaahira Wyne, Shimelse Ali24 July 2012

The US and the Eurozone are slowly recovering after the bursting of their huge housing bubbles. Yet the hardest-hit states in the US have adjusted more rapidly than the most troubled European economies. This column examines differences between the US and Eurozone monetary unions that can help explain why.

The experiences of a few US states in weathering the ongoing economic turmoil could provide some insight into the Eurozone’s struggles. In particular, Florida, Arizona, and Nevada along the US Sun Belt saw a big housing bubble and subsequent bust, much like Greece, Ireland, and Spain along Europe’s periphery, a group we call ‘Club Med’. Both groups, each part of a monetary union, continue to suffer severely from the after effects of the crisis, but the Sun Belt states have recovered earlier and have not faced the trauma of a sovereign debt crisis. Some initial comparisons can be made about the experience of the two groups that could ultimately help shape the Eurozone’s long-term adjustments.

Market-driven adjustment to the crisis

The fact that the United States comes closer to being an optimal currency area than the Eurozone has been widely discussed among economists (see Table 1). But how did the differences between them affect the pace of adjustment in Club Med and the Sun Belt?

Table 1. The Eurozone and the United States Monetary Union

Club Med and the Sun Belt experienced trends that diverged remarkably from the Eurozone and the United States, respectively, in the pre-crisis years. Between 2000 and 2007, average annual GDP growth rates in the Sun Belt states of Florida, Arizona, and Nevada were 1.3 to 2.4 percentage points above the US average, and their recessions were steeper (in 2009 their respective GDPs declined between 2.6 and 3.4 percentage points more than the US average). But they have since returned to growth, though their GDPs remain between 6.9% and 9.1% below their 2007 peak, even as US GDP has recovered its pre-crisis level.

Club Med countries experienced an even-sharper boom compared to the rest of the Eurozone. GDP growth in Greece, Ireland, and Spain over 2000-2007 was between 1.4 and 3.4 percentage points higher than the Eurozone average. However, the fall was also steeper, and there has been no sustained recovery. In 2011, Greece’s real GDP was 13.2% below its pre-recession peak, Ireland’s was down 9.5%, and Spain’s was down a more modest 3.1% but is declining rapidly.

The rise in Sun Belt unemployment was less than half the increase in the Club Med, despite the fact that the decline in GDP from its peak level in both groups is of similar magnitude. Moreover, while unemployment in the three US states has declined by 1.2 to 2.8 percentage points since the worst days of the crisis, unemployment in Club Med is still on an upward trend (see Figure 1).

Figure 1. Change in GDP and unemployment rate

In both groups, the bursting of the housing bubble was associated with an abrupt interruption in the growth of the labour force, presumably mainly the result of a cessation of the big net migration of the pre-crisis years (see Table 2). In Ireland, the collapse in the labour force is especially notable. The much-larger rise in unemployment in Club Med is largely the reflection of a far-larger decline in employment than that seen in the Sun Belt. The very large drop in Club Med employment rates may reflect widely held expectations on the part of employers that the crisis will be long-lived.

Table 2. Change in employment, unemployment, and the labour force (% of labour force in 2007)

Sources: Bureau of Labor Statistics, Eurostat

A possible reason for the quicker recovery of Florida, Arizona, and Nevada is the rapid adjustment of those states’ housing prices compared to Greece, Ireland, and Spain (see Chart 2 for a case in point). Declining housing prices can be expected to accelerate the recovery (or at least the stabilisation) of construction activity and force loss recognition and more rapid restructuring of bank balance sheets.

The pre-crisis increase in home prices was broadly comparable in the Sun Belt and Club Med. Between 2000 and 2006, home prices more than doubled in the Sun Belt (120% in Florida, 106% in Arizona, and 108% in Nevada) while they increased by 76% in Greece, 86% in Ireland, and 121% in Spain.

However, the downward adjustment in prices after the crisis was much faster in the Sun Belt. Between 2007 and 2011, housing prices fell by 43% in Florida and Arizona, and 53.5% in Nevada. In contrast, home prices in Greece, Ireland, and Spain fell by 12%, 33%, and 15% over the same period.1 Concern that banks in Club Med carried large, unrecognised real estate losses deterred lending to them, accentuating the credit crunch.2

Figure 2. Housing prices (2000=100)

Sources: Federal Housing Finance Agency, European Central Bank

State-federal relations and the sovereign debt crisis

In Florida, Arizona, and Nevada, automatic fiscal stabilisers – lower tax liabilities to the federal government and increased receipts of transfers, including unemployment insurance, food stamps, Medicaid payments, and welfare – played a critical role in cushioning the shock. Although a detailed accounting of the Sun Belt – federal government transfers over the course of the crisis – lies beyond the scope here, the effect of these automatic stabilisers is typically to offset as much as 40 cents of every $1 decline in state GDP (Feldstein 2011). This amounts to a large fiscal stimulus over and above that imparted through the American Recovery and Reinvestment Act of 2009, which amounted to 2.8% of US GDP over the course of 2009 and 2010 and which benefited the hardest-hit states disproportionately.

While the net fiscal transfer from the federal government to Florida, Arizona, and Nevada during the worst of the recession may have amounted to 5% or more of their GDP, and remains substantial today as the states’ GDPs remain well below pre-crisis levels, nothing of comparable magnitude exists within the Eurozone. The widely advertised headline numbers of the support given or planned to stem the crisis in Europe are impressive. However, most of these measures – such as the Long-term refinancing operation (LTRO), government bond purchases by the ECB, and Target 2 loans – have their less-heralded parallel in Federal Reserve liquidity support to banks, quantitative easing, and the automatic working of the US monetary union. Moreover, intergovernmental transfers such as through the EFSF/ESM take the form of laboriously negotiated loans to the troubled Eurozone countries, adding to their debt, and are not automatic.

But the most striking difference between Club Med and the Sun Belt is the avoidance of serious crisis in the latter’s government finances. The Florida, Arizona, and Nevada governments represent a small part of state GDP and broadly abide by a self-imposed balanced budget rule; consequently, their deficits and debts represent a small part of their GDP (see Table 3). As the crisis evolved, Club Med saw its credit ratings collapse and its spreads soar. Florida, Arizona, and Nevada’s governments were placed under considerable strain, meanwhile, but their debt problems have not snowballed into state-wide crises, and their credit ratings remain solid. Unlike Club Med, which was forced to cut its deficits while in recession, the Sun Belt governments were able to rely on countercyclical spending, supported directly or indirectly by the federal government.

Table 3. Government finances in 2010

Sources: Bureau of Economic Analysis, US Census, Eurostat.

The credit crisis in Club Med has been greatly augmented by the linking of sovereign risk and banking risk, which is partly the result of large holdings by banks of bonds issued by their national authorities. Unlike Club Med, the Sun Belt did not have to bear the cost of restructuring their banks, and relied instead on the FDIC and other federal vehicles.

The Eurozone: A work in progress

The severity and persistence of crisis in Greece, Ireland, and Spain as compared to Florida, Arizona, and Nevada following a similar asymmetric shock appears to owe relatively little to the inflexibility of the Club Med labour markets and more to the vulnerability of their government finances, the absence of countercyclical transfers, the link between sovereign risk and banking risk, and the slow pace of adjustment in their housing markets. Still, the realisation that the effect of the crisis on the Sun Belt continues to be so severe five years after their housing bubbles burst, despite the support given to them by the Federal government, is sobering, and begs the question as to how far the US is from an optimal currency area.

A more complete treatment would examine the divergence of competitiveness between Club Med and the Sun Belt and their respective monetary union partners. The relatively new Eurozone arrangement has seen the opening of a very large gap in costs between Germany and the European periphery – as much as a 25% difference – while nothing of comparable magnitude appears to have occurred within the United States. For example, between 2003 and 2011, the mean hourly wage in Florida, Arizona, and Nevada remained about 10% less than the US average and consumer prices diverged little as well. On this account, one can speculate that the adjustment of Club Med would be more protracted and painful than that of the Sun Belt even had they been able to rely on a more supportive federal system.

The relevance of this comparison for crisis fighting in the Eurozone today is limited because the differences highlighted are structural and institutional, which change slowly and whose reform is politically fraught. The comparison nevertheless helps us understand why the Eurozone crisis is so extreme and provides some pointers for policymakers on how the Eurozone might evolve in the very long run.

1 It is not clear why the downward adjustment in prices has progressed so much more rapidly in the Sun Belt than in Club Med. One factor could be the prevalence of non-recourse mortgages in the US, which make default less onerous for underwater borrowers. Under these mortgages, borrowers may be quicker to abandon their properties, and the legal system would likely be able to process claims more quickly.

2 More generally, slower bad loan recognition and the absence of a Europe-wide deposit insurance scheme and an adequate Europe-wide resolution processes (paralleling the Federal Deposit Insurance Corporation) have contributed to increased fragmentation of the European banking system and the credit crunch in the troubled countries. Bank lending among euro-area banks fell from $2.3 trillion at its peak in 2008 to $0.96 trillion at the end of 2011, a 60% decline and Eurozone banks have relied much more heavily on borrowing and lending to the European Central Bank.